With mortgage interest rates rising more than 300 basis points in 2022, many homeowners are suffering from the “I hate my house, but I love my mortgage” syndrome. These borrowers have locked in an ultra-low fixed-rate mortgage sometime in the past few years, but under current market conditions, using their home equity to renovate their current home isn’t feasible because the increase in payments for the borrower to “trade up” is prohibitive.
As a result, today’s high rates and borrowers’ accumulated equity present an ideal environment for a responsible expansion of second liens. By taking out a second lien, borrowers can preserve the low rate on their first mortgage while tapping equity to meet cash needs. This cash can be used for debt consolidation, unanticipated expenses, and home renovation. And new homebuyers purchasing a home that has a low-rate Federal Housing Administration mortgage could “assume” this mortgage and bridge the gap between the amount they need to borrow and the outstanding loan balance with a second lien.
Understanding the second-lien market
Let’s say a borrower purchased a $250,000 home in early 2021. They put 20 percent down on a 3 percent 30-year fixed-rate mortgage. As a result, their monthly payment on the $200,000 loan is $843. After two years, the borrower wants to renovate. If we assume the home is now worth $360,000 (consistent with 45 percent appreciation since the start of the pandemic), and the borrower wants to take out $100,000 in home equity via a cash-out refinance, they will pay today’s 6.5 percent mortgage rate on the new loan balance.
For this borrower, paying off the old mortgage and taking out a $100,000 loan would require a new $300,000 mortgage, and their monthly payment would increase to $1,896. But if the borrower kept their existing mortgage and obtained a new 20-year, $100,000 second mortgage at 11 percent instead, the total monthly payment across both loans would be $1,760 ($916 for the second mortgage alone).
Through this example, we see that current interest rates have improved the economics of second liens. At the same time, mechanisms for tapping home equity while preserving the favorable fixed rates are limited. Currently, the borrowers who are obtaining expensive cash-out refinances are predominantly those who have low credit scores and no alternative. Since early 2020, the median credit score for cash-out refinances has dropped from 761 to 691. Current credit scores are lower than they were in early 2019, before the dramatic drop in interest rates.
Instead of pursuing expensive cash-out refinancing, these borrowers could take out a second lien. But the second-lien market is incredibly limited; the following products are available:
- Home equity lines of credit (HELOCs). Primarily a bank portfolio product, these require a very high credit score.
- Closed-end second liens. Although popular during the housing bubble, this product has nearly disappeared for the past 15 years amid tight credit.
Because HELOCs are pristine loans held by banks and credit unions on their balance sheets, they are difficult to obtain; the median credit score is around 775. A niche market for HELOCs also exists outside these institutions in the form of real estate finance firms that make HELOCs for borrowers with high credit scores but not as high as banks require. This market is small, as only 10 HELOC securitizations occurred between January 2019 and December 2022.
Closed-end second liens often do not require credit scores that high, but very few are issued. Between January and August 2022, $53 billion in closed-end seconds were originated, per Equifax, which was a 50 percent increase from 2021. During this period, about half of HELOC originations had credit scores above 780, compared with 15 percent of closed-end second originations.
How originators can develop a robust second-lien market
Despite the presently limited market, there are clear green shoots for second-lien originations. Many nonbank originators have announced that they are originating or will begin originating HELOCs or closed-end second liens. We have seen public announcements by Rocket Mortgage, Guaranteed Rate, United Wholesale Mortgage, PennyMac, and loanDepot. Because it’s a new market, most originations will require high credit scores, but not as high as bank HELOCs. As the market develops, we can expect guidelines will accommodate borrowers with low credit scores, provided nonbanks can find holders for these instruments.
Unlike banks and credit unions, nonbanks can’t hold these loans on their balance sheets. Nonbanks have to rely on a bank or a long-term investor (a mortgage real estate investment trust or portfolio manager) to hold the loans on their balance sheet as whole loans. In the long run, we anticipate these holdings will be aggregated for securitization, as this option is more scalable.
Holding the whole loan requires the investor to be an expert on every aspect of the product, so they can quantify their risk. With securitization, the risk is redistributed and the amount of potential investment dollars increases. That is, more senior bondholders will need to do less work on this product, as the junior bond holders are providing substantial loss protection to the senior bondholders. But unless this securitization market develops, second liens will remain a small niche that primarily serves pristine borrowers.
Additionally, given the small volume of second liens in the past decade, rating methodologies must be redeveloped and investors must be cultivated. The reintroduction of this market will take time. Ultimately, investor acceptance will depend on their confidence in the underwriting process, the updated rating methodologies, and the accuracy of loan-level disclosures in the securitization. Although second liens are not subject to the ability-to-repay rules, it’s in originators’ interest to show investors that these mortgages are underwritten with proper documentation and that borrowers have the ability to repay.
Closed-end seconds were largely banished after the financial crisis. But bringing them back responsibly with proper underwriting can safely allow borrowers with low credit scores to extract equity from their home when cash-out refinancing is not economically feasible. By developing the second-lien market, originators can also allow prospective homebuyers to assume Federal Housing Administration mortgages and obtain the benefit of a lower rate on part of their mortgage.